Comment Text:
Thank you for the efforts that you continue to make regarding the implementation of meaningful and appropriate position limits for the futures markets of finite supply. I am personally an active trader in many different futures markets, including metals, energies, and grains. Although there are many differences between the various markets, I will direct most of this comment today to the Silver market on COMEX.
As I trade each day, I monitor the real-time order flow coming into the various markets, and it's easy to recognize that there are some very large market participants placing outsized orders from time-to-time which send temporary (or extended) shocks to the price action. In our current microsecond centered world of electronic trading, there needs to be an acceptable balance between the market makers (i.e. liquidity providers) with the customer-oriented order flow to achieve a certain level of stability in the price discovery process. The dominating role of certain large traders has caused the real-world available liquidity to shrink, and this exposes the marketplace to unreasonable disruptions. In silver, for instance, the vast majority of market-maker orders are for only one contract each, and thus the arrival of a customer order of any meaningful size can create quite a disruption.
Perhaps the most effective tool that the CFTC has to address this issue is the implementation of strict position limits on speculators. There has been much discussion on this topic, including many voices suggesting a 1,500 contract limit. In my testimony in front of the CFTC on March 25, 2010, I suggested a 2,000 contract limit on all-months combined, with delivery month limited to 1,000 contracts. I continue to strongly believe that numbers of this size are reasonable.
In the current rule proposal, the technique of setting the position limit is based on a mathematical formula including a percentage of the open interest. Although this may be acceptable for some consumable commodities of finite supply, I believe it is very much the wrong approach for the COMEX Silver market. The enormous size the market has grown to (as measured by open interest) is not particularly relevant, but rather real world production and inventories should dictate. After all, the futures markets are more important to serve the needs of producers and consumers, not to facilitate out-sized speculation and possible manipulation.
There should be NO exemptions to this limit other than for bona-fide hedgers, and such exemptions should be granted only on a limited basis upon demonstration of a bona-fide hedge needed for actual market-price risk in their business. An exemption on the LONG side should only be granted to an actual consumer of Physical Silver who has not yet secured a commitment for their silver needs at a fixed price. And an exemption on the SHORT side should only be granted to an actual producer of Physical Silver, and only to the extent that that silver is owned by the producer and has not been presold. Middle-men who actually own Physical Silver which has not been sold could also get an temporary exemption on the SHORT side.
If the delivery-month position limit were for 1,000 contracts (which is 5,000,000 ounces), I believe this would satisfy nearly all of the actual needs of producers and consumers of silver around the world, WITHOUT the need for any exemptions. This is based on the worldwide production levels being approximately 600,000,000 ounces per year. As such, in the COMEX Silver futures market, the bona-fide need for an exemption should be quite rare.
Given the relatively small size of worldwide inventories, annual worldwide production, and annual worldwide consumption, I believe the CFTC should be quite concerned when open-interest gets too large and concentrated. The role that speculation plays in this market is very important to allow bona-fide producers and consumers to transfer their price risk. But, the CFTC must balance the desire for speculators to take large positions with the risk to the integrity of the market, both in the possibility of illegal price manipulation, and in the possibility of exposure to delivery default.
When individual positions are allowed to be over-sized relative the reality of the physical market, then the diversity of representation of various market participants suffers. And, the price discovery mechanism suffers. In this environment, the price action becomes less stable, and the liquidity dries up.
In COMEX Silver, there has been a persistent and large concentrated position on the SHORT side. This over-sized position creates a chilling effect on actual liquidity, as market makers (including myself) must adjust their orders to take this factor into account. And, true liquidity is thus reduced, defeating the goal of fair and efficient price discovery. Additionally, since this over-sized position is in the SHORT direction, it exposes the COMEX to an unreasonable and unnecessary risk of delivery default.
It’s important to remember that being able to trade and hold futures position (either long or short) on a US regulated futures exchange is a privilege, not a right. And, the rules of the CFTC and the Exchanges must be followed, as those rules work to the advantage of the stability of the marketplace as whole. The stability of commerce in commodities of finite supply is most importantly dependent on a fair and efficiently operating futures market. Thus, market participants with over-sized positions which could jeopardize the stability of the futures markets should be viewed with great concern. The benefits of relatively small capital margin requirements to control large amounts of a commodity encourages speculators to want to take big bets via the futures markets. Thus, large positions in the futures markets by speculators is easy to understand. But, the CFTC should guard carefully against this risk.
In summary, I’d like to reiterate the importance of properly-sized position limits in commodity markets of finite supply. I believe a formula that is based on open interest is not the correct way to go about setting position limits. The excessive open interest itself is part of the problem. I believe for COMEX Silver, a responsible position limit would be 2,000 contracts (or 10,000,000 ounces) for all-months combined, and 1,000 contracts (or 5,000,000 ounces) for delivery month.
Thanks for the hard work you are doing to make the futures markets more fair and efficient for all market participants.
-Mark Epstein.
